Despite the dire predictions from the economics profession about Brexit, the UK economy is doing well.
Growth continues at a steady pace. An all-time record 32.4m people are in work. Unemployment has fallen to levels not seen since the mid-1970s.
In contrast, the Eurozone is on the brink of recession – and Italy is already in one.
Economists in the UK are overwhelmingly anti-Brexit. Yet the persistent failures of their forecasts do not seem to lead them to revise their views.
Of course, macro-forecasting is just one part of what economists do. Economics as a subject is fundamentally about the allocation of scarce resources. So economists clearly have a role to play in government, where politicians are constantly having to make trade-offs between what they would like to do and what funds are available.
Even so, we might reasonably wonder whether the massive expansion of the Government Economic Service (GES) under Gordon Brown has been worthwhile. Well over 1000 economists are now employed in the GES.
An altogether more positive view of the point of economists comes from across the Atlantic. The giant tech companies just can’t get enough of them.
Amazon, for example, has hired over 150 economists qualified to PhD level in the past five years. This makes Amazon’s economics team several times larger than the largest academic departments in America.
This phenomenon is the subject of a fascinating article in the latest Journal of Economic Perspectives by Susan Athey of Stanford and Michael Luca at Harvard. Athey was previously the consulting chief economist at Microsoft, and Luca works closely with companies such as Yelp and Facebook.
The close commercial links of the authors are typical of how tech companies are using economists.
Collaboration with the academic world is actively encouraged. But at the same time, as Athey and Luca point out: “the majority of economists in tech companies work on managerially relevant problems with data from the company, and many are in business roles”.
They work on a wide range of practical issues. For example, economists use both actual and experimental data to help decide whether to introduce new products and how to evaluate the impact of competitors.
There are important questions around evaluating not just advertising, but a whole range of marketing initiatives. The skills of economists are very useful in the design and analysis of randomised controlled experiments on these topics.
At the top level, economists get involved in the key strategic decisions of the business. At Microsoft, Athey herself worked on the strategy and empirical analysis of Microsoft’s investment in Facebook and the acquisition of Yahoo’s search business.
It is not all one way. At tech companies, economists have had to become familiar with modern analytical tools in machine learning and artificial intelligence. These are very powerful tools, but academic economists have tended to look down their noses at them.
In the UK, the government is the biggest employer of economists. In the US, it is the tech companies. The contrast shows that we have some way to go to catch up with the entrepreneurial spirit of America.
As published in City AM Wednesday 6th February 2019Read More
The media seems full of gloom at the moment. Chaos over Brexit, Saudi Arabia, potential nuclear escalation between the US and Russia – you name it, people are worried about it.
A ray of light is shone – an apt phrase as you will see – by the work of Bill Nordhaus, a Yale economist who was the co-winner of this year’s Nobel prize in economics, along with Paul Romer.
Over the past two decades or so, Nordhaus has worked mainly on integrating climate change into macroeconomic models, and was awarded the accolade for this research. He is no knee-jerk lefty in this respect. For example, he was a prominent critic of Nick Stern’s report on climate change, which was commissioned by Gordon Brown.
But in my view, Nordhaus should have been awarded the Nobel prize years ago for his brilliant work on measuring how well-off we all are.
The conventional measure of GDP per capita is widely criticised these days. But instead of just whinging from the sidelines about how economics is wicked and useless – sadly a common feature in modern critiques – Nordhaus actually tried to do something about it.
In 1972, he and James Tobin (another future Nobel laureate) developed the Measure of Economic Welfare. The two economists took GDP as their starting point. They adjusted it to include, for example, an assessment of the value of leisure time and the amount of unpaid work in an economy.
Taking these factors into account means we are better off than the conventional GDP measure suggests.
The most dramatic paper by Nordhaus, published in 1996, is on the seemingly obscure topic of the history of lighting. He analysed the topic over a vast time span, from the first sources of artificial light – the fires used by humanity around one million years ago – to the modern fluorescent bulb.
The focus of the paper was not the technology as such, but whether the standard ways of measuring the price of lighting captured the massive improvements in quality which have taken place, particularly in the twentieth century.
Nordhaus concludes that the traditional price indexes of lighting vastly overstate the increase in lighting prices over the last two centuries relative to quality. So the true rise in living standards has consequently been significantly understated.
The magnitude of the difference is vast. Nordhaus estimates that the price measured in the conventional way rose by a factor of between 900 and 1,600 more than the true price.
Bodies such as the Office for National Statistics receive information about the economy in current prices. If output in any particular sector has increased, a key task for them is to decide how much of that is due to a rise in prices and how much to a genuine increase in output.
Rapid quality change means that the conventional ways of doing this simply cannot cope. Price rises are overstated, and in consequence “real” changes in output and living standards are understated.
The implication of the apparently esoteric work Nordhaus did on lighting is that modern technology such as the internet has increased living standards far more than the official statistics indicate. Finally some news to be cheerful about.
As published in City AM Wednesday 25th October 2018
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Gordon Brown’s time as chancellor will be remembered for many things.
A sense of humour would be conspicuously absent from this list.
But he provoked a great deal of mirth unintentionally in a speech shortly before the 1997 General Election on the theme of “post-neoclassical endogenous growth theory”.
Perhaps the last laugh is with Brown. The person who invented the concept, the New York professor Paul Romer, is a joint recipient of the 2018 Nobel prize for his work in this area.
The standard economic theory of growth was set out over 60 years ago in a brilliant paper by the MIT economist Bob Solow.
Solow’s theory was not concerned with the short-run fluctuations in GDP growth over the course of the business cycle. He set up a framework for thinking about what determines growth in the longer run.
Solow argued that the growth in output was related to the growth of inputs of labour and capital into the productive process.
This seems obvious. But there was an extra ingredient: innovation.
This embraces a wide range of concepts, from becoming more efficient at producing what you already do, to major scientific breakthroughs.
Economists quickly used Solow’s model to estimate empirically what was really driving economic growth. In western economies, the answer was almost always the same. The amounts of labour and capital used had risen, but nowhere near enough to account for how much growth had taken place.
So the key factor in economic growth in the longer run is the amount of innovation which is carried out.
This insight is directly relevant to the debate over Brexit. Over a 10 or 20 year horizon, the key question is not the terms under which we leave – it is whether we will be able to innovate more effectively in or out of the EU.
The basic shortfall of the approach is that innovation itself is not explained by Solow’s model. Innovation is, in the jargon, “exogenous”. In other words, it is determined externally to the model.
This is where Romer enters the stage. His seminal paper in the Journal of Political Economy in 1986 is full of heavy-duty maths. The crucial difference with Solow is that the rate of innovation is determined within the theoretical model itself – hence the phrase “endogenous” – by profit-maximising firms.
Physical capital such as machinery, warehouses, and roads play a role in both the Solow and Romer theories of growth. But Romer introduced the key concept of knowledge as the basic form of capital.
Policymakers across the west in the past two decades have been obsessed by the “knowledge economy”. This is not, as Tony Blair and many others believed, simply a matter of sending more and more people to university. It is about how to encourage innovation.
Both the Solow and the Romer models are highly abstract – Solow, for example, began his article with the phrase “all theory depends on assumptions which are not quite true”. But both have been highly influential with policymakers, and illustrate the vital economic importance of ideas.
As published in City AM Wednesday 18th October 2018
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What does someone with the job title of “chief economist” actually do?
The most well-known in the UK is probably Andy Haldane at the Bank of England, but his role is not typical. So what do the others do?
Nobel Laureate Alvin Roth’s paper in the latest issue of the American Economic Review describes the rapid evolution of the role of chief economists. Their main activity in commercial companies, banks, and investment firms was in macroeconomic forecasting – inflation, GDP growth – with perhaps some specific market commentary on the side.
These still exist, though there are fewer of them. And they are a cost to the business, rather than a revenue generator.
But the role is changing. Now, the major tech and internet companies employ chief economists – Airbnb, Facebook, Microsoft, and Google all have them. And the content of the work is completely different.
As Roth writes, “market design has opened up new ways for economists to earn a living”. Instead of being a cost centre, this new breed of chief economist and their teams make money for the company by designing the marketplace it hosts.
For example, in the short time between you clicking on the web and the site appearing on your screen, auctions have taken place.
Google search auctions determine which ads to show for each word that someone is searching. As Roth puts it, these are auctions for “eyeballs” – for attention. Auctions for banner ads on websites may involve bids based on the cookies that reveal data about the previous web activity of the eyeballs being auctioned.
These auctions have to be very fast and very efficient. The design of such markets at the hands of chief economists has become a lucrative business in its own right.
Roth’s paper of course covers much wider ground. As its title, “Marketplaces, Markets, and Market Design” suggests, it illustrates the important advances in economics recently in understanding how markets actually work.
Markets such as those for commodities conform closely to the simplified ideal presented in the basic textbooks. They allow trade to be conducted with relatively anonymous counter-parties, with prices doing all the work of deciding who gets what.
But even here the process by which prices are set needs to be specified, as does the definition of what the commodity actually is. The Chicago Board of Trade, for example, deals in commodities like US soft red winter wheat, not just “wheat”. And there need to be people whose job it is to specify such things.
Many of the features of price changes in financial markets, such as there being far more very large changes than a standard approach suggests, appear to arise from the price-setting mechanism, the double auction. We do not yet understand why. But according to Roth, “practical market design must often proceed in advance of reliable theory”.
John Maynard Keynes looked forward to the day when economists would be regarded in the same way as dentists, people doing a useful practical job. But Roth sees the recent developments in market design as making economists more like engineers. Surely a good thing, given that their bridges usually stay up.
As published in City AM Wednesday 4th July 2018
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Criticisms of economics have abounded since the financial crisis.
Even Nobel Prize winners like George Akerlof of Berkeley have got in on the act. A key demand is for economics to adopt a more recognisably human portrait of behaviour in its theories than the rational calculating machine of the textbooks.
Psychology rather than pure economic theory is needed, apparently.
The simple fact is that economics has moved on a great deal in recent years. Much of the success of behavioural economics is based upon incorporating insights from psychology. But economists have done this in their own way.
As top behavioural economist and Nobel laureate Richard Thaler notes in his book Misbehaving: “behavioural economics has turned out to be primarily a field in which economists read the work of psychologists and then go about their business of doing research independently”.
It turns out that this approach seems to have been a very sensible one. Famous psychological experiments have recently been shown to be without foundation.
The most glaring example is the 1971 Stanford Prison experiment, one of the most influential psychology studies of all time.
Students were randomly assigned to be either guards or prisoners within a mock prison. The objective was to observe the interaction within and between the two groups.
The results proved shocking, with the abuse handed out to the prisoners by the guards so brutal that the study had to be terminated after just six days.
There were already doubts about the results. Other psychologists had found them difficult to replicate. But it has emerged this month, from analysis of previously unpublished records and interviews with some of the participants, that results were simply faked.
Another famous study, the so-called marshmallow test, has also been debunked.
In the original research in the 1960s and 1970s, children aged between three and five were given a marshmallow that they could eat immediately, but told that if they resisted eating it for 10 minutes, they would be rewarded with two marshmallows. More than a decade later, in their late teens, it was claimed that the children who had resisted exhibited advanced traits of intelligence and behaviour far above those who caved in to temptation.
But by the straightforward expedient of taking into account the economic and family backgrounds of the children, almost all the differences claimed for the ability to delay gratification disappear.
Ironically, it is economists themselves who have shown that western societies as a whole, not just particular groups, have great difficulty in deferring gratification.
The Chicago economist David Laibson established the idea back in 1997 in a famous paper with the rather gnomic title of “Golden Eggs and Hyperbolic Discounting”. The obscure phrase “hyperbolic discounting” means that people assign a great deal of weight to costs and benefits incurred in the present and very near future, and very little weight to anything beyond that.
Economics may have its faults, but much of psychology seems to be built on sand. Perhaps it is psychology that can learn from economics.